Emerging markets on the bubble

You have to love emerging market stocks. After all, they are up more than 40 percent for the year -- an even more tantalizing return than the 31.6 percent average for each of the last five years.

But should you love them and leave them?

Analysts are starting to use the word "bubble" for emerging market stocks. Yet many are telling investors it's still not time to bolt just yet. They urge investors to watch stock valuations and performance, along with the prospects for either inflation or recession, to help determine where stocks are likely to be headed.

Many are suggesting investors continue to partake in the momentum as emerging markets benefit from another round of easy money from the U.S. Federal Reserve's recent rate cut, plus a tendency by global fund managers to chase growth-spurt countries from Asia to Latin America.

But they are warning that easy money and momentum work two ways -- inflating stock prices at first but sometimes causing manias that go too far, and end badly.

Emerging markets -- in usual form -- fell harder than developed markets, as investors fled stocks in July and August amid concerns about the impact of the U.S. subprime bond mess on the worldwide financial system. While the Standard & Poor's 500 dropped 9.4 percent, emerging markets lost 14.4 percent. Yet, as fear subsided, emerging market stocks sprang back powerfully, gaining 25 percent since Aug. 19.

For the year, the MSCI Emerging Market index is up 41 percent, and the S&P/Citigroup Latin America index is up 51 percent.Developed markets -- including the U.S., Europe and Japan -- have been no match. For the year, the U.S. S&P 500 is up about 10 percent. Japan has limped along at roughly 2 percent.

The emerging markets, which provide commodities to the world and also consume them as they build highways to housing for a growing middle class, have followed the trend in commodities prices. For the year, energy stocks are up 27 percent, and materials are up 23 percent, according to S&P.

Analysts say that if areas such as China and India continue their tremendous growth, and the U.S. avoids a recession, the prices of emerging market stocks are not out of line. But they are starting to reach levels that are making some analysts cautious.

"As the current up leg in emerging market share prices continues to gain momentum, it is time to ask what will cause the next shakeout," BCA Research said in a recent report.

Typically, emerging market stocks -- measured by prices compared to their earnings -- have sold at a discount to stocks in developed countries because of the added risk. But that is no longer true.

They are running neck and neck now, with emerging stocks about 13.3 times earnings compared with 13.4 times for developed countries, said T. Rowe Price emerging market portfolio specialist Todd Henry.

With stock prices on emerging stocks that high, there is extra risk to investors, he says.

"There isn't a lot of room for disappointment," he said.

Stocks could fall significantly if earnings growth doesn't materialize as expected. And growth worldwide is in a slowing trend. Earnings in emerging markets are expected to climb 14 percent this year, compared with 41 percent in 2003.

For developed countries, this year's estimate is 8 percent, compared with 19 percent in 2003.

Henry notes that in 2007, emerging market stocks are in the opposite position as they were early in the 2000s. Then, the stocks had been ignored for years. During the five years up to 2001, they had climbed only about 1 percent a year. It was, in part, because they were so cheap that they soared so powerfully over the next five years.

Rather than being attracted by prices climbing 40 percent now, Henry says "that's a bit of a sign -- a red flag."

Still, whether investors should flee, or stick this one out, depends on the type of investors they are. Henry notes that T. Rowe Price growth fund managers, which take on risk, are weighting emerging market stocks heavily -- at close to 25 percent of international portfolios. Meanwhile, value managers who avoid stocks when they become pricey and risky have reduced emerging market exposure significantly.

But Henry and other analysts are warning investors who want to ride the momentum further to do it with their eyes open.

If investors see a threat of a U.S. recession, he said, emerging markets could drop 25 percent.

On the other hand, if they continue to ride the wave they are on and climb another 20 percent by the end of this year, Henry warns they could be in a precarious position.

Hartnett is providing a similar warning. But he thinks, ultimately, the threat to emerging markets will be inflation rather than recession.

In the short term, he notes the fourth quarter of the year is usually strong for emerging market stocks: They climb on average 7.8 percent. And this year, he says, they could be propelled by fund managers who accumulated cash during the July and August stock sell-off. Those managers are looking for places other than the U.S. to invest.

But Hartnett advises momentum investors to watch for signs that the bubble will burst.

For example, he suggests watching stock charts that track prices.

A parabolic climb in the stock price -- or a line that climbs sharply on a graph -- signals that the end is probably near. In 2000, that's what technology stocks did.

Hartnett also says to watch for higher inflation and higher bond yields, or the price of emerging markets reaching 23 to 25 times earnings.

Another warning would be fewer stocks in the MSCI Emerging Market index outperforming the average. For example, in early 2000, before the technology bubble burst, 30 percent of stocks were doing better than the S&P 500.

Henry says that when emerging markets fall it is typically very hard and very fast. For newcomers to emerging markets, he said, it would be more sensible to indulge after such a fall rather than now.

Hartnett said he thinks the best upside will be through BRIC markets, where investors will take advantage of both the commodity markets and also growing domestic demand for products. Investors can invest in it through vehicles such as the Goldman Sachs BRIC or Templeton BRIC mutual funds or Claymore BRIC exchange traded fund.

A more diversified approach would be to invest in all emerging markets through an emerging market fund or the iShares emerging market exchange traded fund (EEM).

Another approach would be to invest in international funds or global funds that provide fund managers with the leeway to move in and out of areas that seem attractive or overpriced.

S&P recently suggested that investors be cautious about picking individual emerging market countries such as China or India.

Instead, the firm suggests that investors simply keep 5 percent of their portfolio in emerging markets on a routine basis, and select diverse exposure such as the EEM exchange traded fund.